Second-Lien Exposure Rising for US CLOs

Second-lien exposure in US broadly syndicated loan (BSL) collateralized loan obligations (CLOs) is on the rise after a decline since the latest peak in mid-2015. Recently launched US CLOs rated by Fitch Ratings have been building in higher limits for second-lien exposure, likely for flexibility to manage weighted average spread (WAS) pressures.

Spread compression pushed more than half of the BSL CLOs at each vintage level very close to their WAS covenant thresholds. As of YE 2017, 18% of Fitch-rated BSL CLOs were failing their thresholds.

Most of the WAS test failures are from the 2016 vintage (26.0%) and 2014 vintage (25.5%). CLOs primarily hold the senior secured first-lien term loan from leveraged transactions in their portfolios and these loans' margins compressed in 2017, resulting in WAS pressure. The average first-lien spread declined to 335bps, at the end of first-quarter 2018, compared with 429bps, at the end of first-quarter 2017, according to Fitch collected data and/or from Thompson Reuters LPC (TR). The spread on second-lien loans also compressed, but averaged 725bps, at the end of first-quarter 2018, and second-lien loan issuance volume spiked, totaling $32.4 billion in 2017, up from $22.1 billion in 2016, according to TR. First-quarter 2018 issuance of $7.3 billion was just under the first-quarter 2017 figure of $7.4 billion.

Typical maximum portfolio concentration limits for second-lien exposure for US BSL CLOs are 4.0%, 7.5% or 10%. In transactions that priced in first-quarter 2018, more than 80% of indentures include the 10% basket, compared to 57% in the previous quarter. This pushed the average for the maximum second-lien covenant to 9.4%, above 9.0% for the first time since 2015.

The higher limit will not necessarily reflect actual second-lien appetite. The average exposure for the 403 US BSL CLOs monitored by Fitch was 2.2%, as of March 31, 2018, up from 1.8% one year earlier. The peak average second- lien exposure for Fitch-rated US CLOs was 3.4% in 2015. The most widely held second-lien loans were issued by Asurion, LLC, Capital Automotive, L.P., and Almonde, Inc.

One hurdle to increasing second-lien exposure is CLOs still have to meet collateral quality tests, including weighted average recovery rate minimums, while reinvesting. Nearly 50% of the issue ratings and credit opinion estimates for second-lien issues were rated 'RR6' with a 0% to 10% estimated recovery in Fitch's US corporate portfolio, as of December 2017.

Fitch expects a healthy second-lien term loan new issue volume in 2018, but volumes are unlikely to be record-breaking this year, as a result of some headwinds. While investors remain willing to accept leveraged capital structures, and sponsors aim to maximize total leverage in deals, issuers will still try to use first-lien debt. The overall leveraged loan market is expected to be less active and limits on the tax deductibility of interest expense will hold the second-lien market back.